Advanced planning

Cross-purchase buy-sell agreement

After your client invests significant time, sweat and resources into their business, it is important to have a plan to harvest the return on that investment and to successfully transition ownership. As they plan to transition their business in the future, they can use a buy-sell agreement to determine the purchase price, the funding source, and what will initiate the agreement. A buy-sell helps ensure your client and their family will receive the full and fair value for their share.

One of the most common types of buy-sell agreements is a cross-purchase. In a cross-purchase buy-sell, your client and the other business owner(s) agree to buy the business interests of an owner who dies, becomes disabled, retires, or otherwise leaves the business.

How it works

Your client and the other business owner(s) draft an agreement for an orderly transfer of the business following a triggering event such as death, disability, or retirement of an owner. The plan outlines how the interests/shares of the departing owner(s) will be purchased by the remaining owner(s). In turn, the departing owner (or his/her estate) agrees to transfer his/her interests to the other owner(s) for the agreed upon price when the triggering event occurs. The remaining owner(s) will end up with the entire business and the departing owner’s family will receive the pre-determined price in exchange.

Funding with life insurance

Life insurance is an ideal funding source because it is often the most affordable option when compared to other choices such as a bank loan, sinking fund, or installment sale. Life insurance proceeds are income tax-free providing liquidity exactly when it may be needed most. Additionally, permanent life insurance can accumulate cash value to help fund a buyout upon disability or retirement.

With a cross-purchase, your client and each business owner purchase an insurance policy on the life of each other and are the beneficiary of the policy. Each owner pays the premiums on each policy that he/she owns. Upon disability or death of a business owner, proceeds from the disability or life insurance policy pass to the surviving business owner(s) who use the proceeds to purchase the business interest from the departing owner.

The benefits

• Surviving owners receive an increased cost basis (the original value of an asset for tax purposes) in the acquired business interest which may reduce any future taxable gain.
• Life insurance does not increase the buyout price because the business does not own the policies.
• A buy-sell agreement can create a degree of stability that may be important to creditors, suppliers, employees, and their families.
• Your client and the other owner(s) can agree how the purchase price and terms will be determined no, rather than waiting until death or disability which could potentially reduce the value of the business.
• Business succession planning combined with the guarantees of life insurance can help provide your client with peace of mind.
• For a two-owner business, due to its simplicity and tax advantages, the cross-purchase is the most common type of agreement. It requires only one insurance policy per owner and the remaining owner receives an increased cost-basis after purchase.

Additional considerations

• While the “swap” powers give flexibility, the trust document is typically irrevocable and cannot be changed except as the trust itself allows.
• Cross-purchase agreements generally work best when there are three or fewer business owners. Otherwise, the agreement can become administratively complicated.
• The number of policies needed is the number of owners multiplied by the number of owners minus one. For example, a three-owner business would generally require a total of six insurance policies to fund the agreement.
• If a significant age or health disparity exists among owners, the younger or healthier owners will pay higher premium payments on the policies insuring the older or less healthy owners.
• Life insurance premiums paid are generally not tax deductible to the individual owners.
• Upon the death of an owner, his/her estate will own policies on the other owners. If the other owners purchase the policies from the deceased owner’s estate, the purchase may be subject to special tax rules.
• A fringe benefit plan such as a bonus or a split-dollar arrangement may be possible to help defray the buyer’s personal cost of the life insurance policy (for C-Corporation owners). To learn more, talk to your financial professional.
• Work closely with a business planning attorney to design and create a buy-sell agreement that works best for your client.